Question

explain in your own 200 words

Explain the difference between fixed and floating exchange rates.

Answer 1

(a) Fixed Exchange Rate System:

Fixed exchange rate is the rate which is officially fixed by the government or monetary authority and not determined by market forces. In this system, foreign central banks stand ready to buy and sell their currencies at a fixed price. A typical kind of this system was used under Gold Standard System in which each country committed itself to convert freely its currency into gold at a fixed price.

Merits:

(i) It ensures stability in exchange rate which encourages foreign trade, (ii) It contributes to the coordination of macro policies of countries in an interdependent world economy, (iii) Fixed exchange rate ensures that major economic disturbances in the member countries do not occur, (iv) It prevents capital outflow, (v) Fixed exchange rates are more conducive to expansion of world trade because it prevents risk and uncertainty in transactions, (vi) It prevents speculation in foreign exchange market.

Demerits:

(i) Fear of devaluation. (ii) Benefits of free markets are deprived; (iii) There is always possibility of under-valuation or over-valuation.

(b) Flexible (Floating) Exchange Rate System:

The system of exchange rate in which rate of exchange is determined by forces of demand and supply of foreign exchange market is called Flexible Exchange Rate System. Here, value of currency is allowed to fluctuate or adjust freely according to change in demand and supply of foreign exchange.There is no official intervention in foreign exchange market.

Merits:

(i) Deficit or surplus in BOP is automatically corrected, (ii) There is no need for government to hold any foreign exchange reserve, (iii) It helps in optimum resource allocation, (iv) It frees the government from problem of BOP

Demerits:

(i) It encourages speculation leading to fluctuations in foreign exchange rate, (ii) Wide fluctuation in exchange rate hampers foreign trade and capital movement between countries, (iii) It generates inflationary pressure when prices of imports go up due to depreciation of currency.